I reader asked me to write about what I think the current inflation situation is. Here goes:

warming up

In an inflationary environment, prices are generally rising. In a deflationary one, prices are generally falling. It’s not just about prices, though, it’s also that different economic environments change people’s behavior and beliefs.

In a developed economy like the US, the principal price is wages.

We live in an inflationary world, which is ok if the rises are slow and predictable. The Great Depression of the 1930s demonstrated that deflation, a world of falling prices, is far, far worse.

If you’ve gotten the biggest mortgage you can afford so you can buy a house, and then wages start to drop at 10% a year, pretty soon you don’t make enough to make the payments any more. Both you and the bank are in trouble. If the place you work has borrowed, too, it may be forced into bankruptcy, leaving you homeless and out of work.

South America is littered with cautionary tales of what can happens when inflation runs out of control. When people lose their belief in the value of their currency, they stop saving and begin to buy anything that they think will preserve purchasing power–from gold and silver to used cars and power tools. The US had its own bout with this in the late 1970s. It took interest rates at close to 20% and a decade of austerity to break the hoarding reflex in consumers’ minds.

Inflation near zero also has its problems. Japan is the poster child here, with negligible inflation but virtually no economic growth for the last three decades.

The consensus of academic economists is that the best situation is having some inflation, but not too much.

money policy during the financial crisis

By 2000, inflation in the US was relatively steady at around 3%. Academic economists argued that the optimal rate should be 2%, and that we should reduce inflation to that level. They said that if that assumption proved to have negative economic consequences, then we could always push it back up to 3%.

Then the 2008-09 financial crisis happened, causing a year of deflation in the US in 2009. Money policy alone was barely able to nudge the country out of the furrow plowed by Japan in the 1990s–and even then only maybe a couple of rows over. Congress was its usual inept self and almost no help at all. Republicans argued a second Great Depression would be better than bailing out the banking system. Only a stock market freefall after their vote against any relief produced aid that was perhaps a quarter of what was needed.

I think this near-disaster is what has motivated the domestic economic community to approve of a policy that has been consistently erring on the too-loose side recently, in an attempt to create a comfortable distance between us and debilitating deflation.

today’s inflation

I think the major story is a temporary surge in demand. For example:

I started kayaking during the pandemic. Last spring I decided to buy a touring kayak so I could paddle longer distances. That’s when I discovered there was a kayak shortage.

Touring kayaks are a cottage industry, where unit demand grows by 1% or 2% a year. Suddenly, demand is up by, say, 30%. If I’m a manufacturer, what do I do?

I can increase capacity, meaning buying new molding machines and hiring/training new workers. I make a lot more money this year. But as the world returns to normal, demand drops back to the old level. Most likely, demand sinks below the old level (maybe way below) for at least a year. That’s both because some customers who would have bought in 2022 did so in 2021 and are no longer in the market for a kayak and because some of the 30% of newbies realize they don’t like kayaking, or no longer have time for it. So they put their barely used boats up for sale, depressing both demand and prices.

Now I’m stuck with the new machines and a bunch of workers I have to lay off because new orders in 2022 have melted away. Why take the risk of destroying a family business that’s worked just fine for, say, the past twenty years?

What makers have, in fact, done is, I think, the most economically sensible thing–they’ve raised production a little and upped prices by 10%. Long experience has taught them that surges in demand like this can come and go very quickly.

In a technical sense, the price rise is inflation. But there’s no reason to believe–and every reason not to believe–that this is the first in years-long series of price hikes that will convince people to hoard kayaks as a kind of savings, as a substitute for having a bank account or money in the stock or bond markets. What’s happening now is not the kind of inflation that occurred in the late 1970s in the US.

I think this sort of thing–one-off price rises–is what’s going on in the world economy now. The long-standing problem of very inefficient ports on the West Coast probably make the situation a bit worse in the US than elsewhere. Typical bungling by the “Big Three” US automakers likely also contributes. My guess is that we’re at or near (maybe even past) the peak of yoy price increases and will soon return to normal. This is also what the 10-year Treasury at 1.4% seems to be saying.

I continue to think that the tech sector is, broadly speaking, is in the process of bottoming. By “broadly speaking” I mean to include all of the 40% of the S&P 500 that’s techish. I don’t mean every single stock in the sector, either.

Assuming I’m correct, there are several things I think we should be aware of and paying attention to:

–in my experience the bottoming process takes much long than most people (i.e. me, in particular) would like or expect. My picture is that there’s always some holdout who says to himself “If I only hang on a little longer, take the pain, then it will all be over and I’ll look like a hero for not selling.” But the selling usually doesn’t end until that person loses it and sells at least something

–double bottoms are one of the few technical things–support/resistance is another–that I believe in. Sometimes, selling ends and the market, or in this case, the sector, bounces right back. Most times, however, the market/sector goes back to the original bottom to “test” it several weeks after establishing the initial low

–in the current case, I suspect the process will be complicated by the end of the calendar year–basically almost all professionals will take their hands off their portfolios at the end of this week or early next and do nothing until January trading starts. Retail investors now doing tax-loss selling will likely do the same

–I think this is a time to pay close attention to individual stock charts, trying to gauge investor sentiment. My guess is that we will be able to divide stocks into two piles as follows: one where buying comes in to support the stock at a certain point, possibly yesterday’s intraday lows; and another where the stock continues down to make new lows. Typically, members of the second pile will still have a rocky road ahead of them as/when selling abates.

one

With the caveat that I’m always too early on this sort of thing, it seems to me that the downward momentum is slowing substantially for the speculative stocks that have borne the brunt of recent selling. I don’t think potential sellers have run out of ammunition; I think prices are probably low enough that they think it no longer makes sense to push these stocks down further.

Two reasonable courses of action, I think:

–do nothing, if you’re basically satisfied with your portfolio, or

–look for stocks to buy/add to that have been pulled down by ferocious selling without much reason that this should happen, or that have been beaten down to the extent that either their assets or their potential could be worth more than the current stock price. Peloton (PLTN), for example, is now down from its high of $171 to around $37 as I’m writing this. I’m not sure it can be a winner with current management, but it might be a bet on change of control–a standard “value” strategy.

two

I read yet another article beating up on Cathie Wood. This is the second time I’ve heard the story that in all likelihood more money has been lost from holding the ARK flagship fund, ARKK, than has been made over its history. Yes, this may be true and, yes, fifty percentage points below the S&P 500 in a bit less than a year is a stock market calamity for the ages. But the reality is that investors of all stripes, both institutional and retail, chase performance. That is, by and large they buy high and sell low. The amounts of money at stake in the ARK case may be unusually large, but the total losses being greater than total gains isn’t the shocker it is being presented as.

At the same time, the financial press also seems to me to behave the same way: to chase rather than anticipate. If anything, these negative stories could be seen as another sign of the bottom for ARKK stocks.

The real question for holders of ARK funds (I’m one), I think, is whether Ms. Wood can/will/wants to modify her investment style. If she can’t/won’t/doesn’t want to, then my approach should be to treat her funds like individual stocks and take on myself the task of judging whether the contents are cheap of expansive–rather than leave this portfolio management task to her.

repositioning takes time

It has been very clear for a long time, let’s say June of this year at the very latest, that interest rates in the US were not going to go any lower, that the next major move would be to establish an interest yield on bonds that’s higher than inflation (this is normal), and that the first steps would happen before yearend.

With economic activity running stronger in the US than elsewhere, and supply-chain-problems creating unwelcome price increases, the Fed indicated during the summer that it would make these initial moves starting in November.

It seems to me that investors only began to seriously reposition their portfolios in reaction to the idea of a sea change in monetary policy in September, accelerating their activity in November and December.

You’d think that this would happen all at once. The ship captain sees the iceberg approaching and reacts by steering out of the way. But Wall Street doesn’t work that way. It makes one small change, followed by another, and then another …and then makes a final rush to do what arguably it should have done months before.

How so?

First, in 40+ years of watching the stock market, this little by little approach is what investors, professional and otherwise, do. As to why, I have no 100% satisfactory answer. I think part of it is like watching an engrossing movie in a theater and smelling smoke. The sensible thing is to get up and leave, but no one else is doing this and the movie is sooo good.

Part of it, also, is a reluctance to make all-or-nothing bets in a business where being wrong only 40% of the time is a winning performance. In addition, customers–or at least the consultants they hire to monitor performance–have no tolerance for a manager who sells ABC at $40, realizes this is a mistake and buys it back at $50 six weeks later. That gets you fired, even if the stock goes up from there. Selling it as an established dud at $30 doesn’t.

All in all, a very significant change like a reversal in direction of monetary policy probably takes six months of digestion before it’s fully baked into stock prices.

the yearend

There are only a handful of days left in pre-holiday trading. Institutional investors and market makers are already in the process of winding down operations. My sense is that because of this there are fewer potential buyers around than normal. On the other hand, there are lots of (taxable) retail investors, relatively price insensitive and only wanting to sell losing positions to establish tax losses for the current year. I think the combination results in wide swings in markets, with a bias to the downside.

the odd case of Cathie Wood

From its high in mid-February, the flagship ARK fund, ARKK, is down by about 40%. Over the same span, the S&P 500 is up by 19% and NASDAQ by 9%. This performance is almost as jaw-dropping on the downside as her epic relative–and absolute–gains last year were to the upside.

I was struck by a recent Financial Times article about ARKK in which a former boss of Wood’s is quoted as saying that, although a visonary, “…her biggest blind spot is managing risk and volatility.” What I understand this to mean is something like: if we were betting on coin flips, one bet is to wager $2 with a 50/50 payoff of $10; another is to wager $10 with a 50/50 payoff of $2. Wood isn’t able to distinguish between the two situations in her portfolio construction.

I have no idea whether this is true, although I do find it odd that she continues to double down on stay-at-home stocks like Zoom and Peloton (both of which I once owned and have long since sold). The point I want to make, however, is that no one normally says stuff like this about a rival. Added to crashing tech stocks, it makes me think we’re at or approaching another market inflation point.

more tomorrow

For the US stock market,

–2017 was all about discounting the tax law change being passed by Congress that would cut corporate taxes by around a quarter

–2018 and 2019 were all about the inept, economic growth-inhibiting policies of the Trump administration, with a slowly building undertone of capital flight. Both implied favoring multinational businesses and firms with intangible assets over US-based plant and equipment

–2020 was mostly about the pandemic-induced stay-at-home economy plus Trump’s inept “drink bleach” response to–and the possibility he would be reelected. Stay at home was a new element. Otherwise, until November, 2020 was 2019 on steroids. Once Trump lost, covid remained a key issue but the market began to broaden out to include domestic names

–2021 has had two different, though interrelated, themes. Around mid-February, the availability of large amounts of vaccine began to lessen the attractiveness of stay-at-home. The counter move, back-to-normal, has been relatively slow to develop, however, but could easily be an important part of investor thinking in 2022.

Second, the robustness of the US economic bounceback this year, which has been much stronger than elsewhere in the OECD, has caused the Fed to decide to reduce its emergency monetary stimulus earlier than it and Wall Street had initially thought. This means higher interest rates–they couldn’t be lower than now, anyway–in 2022. I’m planning with the idea in mind that the 10-year Treasury, now yielding about 1.5%, will end up at about 3% before Fed tightening is done, maybe a year from now. Maybe that’s too high, but I think it’s better to assume a number that’s too high than to underestimate the scope of upcoming tightening.

The idea of a ten-year instrument with an interest yield of 3% in the near future is likely worse for bonds as an asset class than for stocks, since the S&P has a dividend yield that’s slightly higher than the 10-year and because stock valuations will generally be underpinned by what I expect will be considerable US-driven earnings growth next year. Within the stock market, however, interest will likely be focused away from the concept-driven, earnings-poor “story” or “concept” stocks that thrived in a zero interest rate world toward perhaps more prosaic names that will be exhibiting strong earnings expansion.

I think that looking at the course of ARKK, the flagship Cathie Wood-managed fund, illustrates how much of this has already happened.

In mid-February 2021 ARKK had gained +23.2% ytd (S&P at +5%). By mid-May the fund was down ytd by -23.2% (S&P at +12%). I attribute this fall to the shift away from stay-at-home.

By early November, ARKK had rallied to -1.6% (S&P at +24%). As I’m writing this, however, the ETF has fallen to -26.1% ytd. This compares with the S&P at +25%. I read this as the stock market beginning to discount the end of the zero interest rate “free money” environment. Unlike the case with stay-at-home stocks, the most important factor with “story” stocks is not that the earnings prospects for early-stage companies have diminished. It’s that the market is coming to believe that the opportunity cost of holding these names is about to increase by a substantial, but as yet unknown amount (which makes the situation worse).

Experience tells me that the decline/revaluation in concept stocks is closer to its start than to its finish. On the other hand, the reaction to disappointing earnings reports has been jaw-dropping. Docusign, which I know nothing about other than that I’ve been a user, fell by 42% on its last report. Again, I have no real idea why. I surmise, however, that AI selling encountered a complete disappearance of potential buyers. It could be that for a (possibly long) while these names will be in a bear market of time rather than of continuing diminishing valuation, although I wouldn’t want to bet that this will be the case.

Where will money flow to? My guess is that the Consumer Discretionary sector will be a big beneficiary. One of my sons is suggesting the mega-cap tech names. That’s probably right, too, especially since IT + Communication Services together make up over 40% of the market cap of the S&P.

more tomorrow